The Dividend Growth Investor's Version Of 'A Christmas Carol'

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Includes: ABBV, ABT, ADP, CLX, HCBK, MKC, MTB, PEP, PG, SYY
by: Chuck Carnevale

Summary

The principles of quality and sound valuation should be indelibly imprinted in your investing DNA.

There is no substitute or better teacher than experience.

The most valuable investing principles are supported by common sense.

Stock price volatility challenges our good judgement and stimulates strong emotional responses.

Investing at sound value is about paying a fairly reasonable price supported by fundamentals.

Introduction

Another year is coming to an end as we are entering the "Holiday Season" of 2014. This is my favorite time of the year for several reasons. Getting into the holiday spirit, and seeing others do the same is the primary reason. However, I also take vacation time during the holidays, but also use this time for reflection and planning for the future. First, I appreciate the present, then think back on the past, and as the New Year approaches, on to the future.

I have been writing articles for Seeking Alpha since June of 2009. Over that entire time frame, and over the majority of my more than 40 years in the financial services industry, I have observed a penchant for many investors for having a jaundice and even bitter view of investing in stocks, and the stock market in general. Consistent with entering the holiday season, these prevailing attitudes bring to mind the critically acclaimed novella - A Christmas Carol by Charles Dickens. The lead character, Ebenezer Scrooge, was a bitter old man and miser. Until, of course, he was visited by the ghost of Christmases past, present, and yet to come.

As it specifically relates to Seeking Alpha, and the purpose of this article, I thought it would be interesting to conduct a review of some of my initial contributions. My first article on Seeking Alpha appeared on June 11, 2009 and was titled "Rockwell Collins: The Best Offense Is a Good Defense." For the next several months, most of my contributions were written about individual stocks, both growth stocks and dividend growth stocks.

On March 29, 2010, I presented my first series of articles covering a group of 8 high-quality dividend growth blue chips that I considered undervalued based on the historical reality that each of these dividend growth stocks typically commanded a quality premium valuation. The primary emphasis of this series of articles was on investing in high-quality blue chips. Secondarily, I was reporting on the advantages and opportunity of investing in them when their valuations were sound.

As an aside, although the investing principles of quality and sound valuation were already indelibly imprinted in my investing DNA, I found it interesting that my writing skills seemed somewhat primitive compared to where they are now. There is no substitute or better teacher than experience. Even more interesting to me personally, was to see how far the F.A.S.T. Graphs fundamentals analyzer software tool has also grown and evolved since that time. In short, it was an eye-opening and illuminating exercise for me personally. But most importantly, it inspired me to offer this current work.

At this point, I feel it's necessary to interject that what I am about to present with this article is neither to boast about past successes, nor to fess up to past mistakes. The primary purpose of this article is to discover, evaluate and learn all that I could by studying and evaluating my past investing behaviors and actions. This is a habit that I have engaged in over my entire career in the financial services industry. Although I believe there is much to learn from analyzing past successes, I contend that there is even more to learn from studying past mistakes. My objective has always been to see what lessons I could learn, and then use that knowledge to make better decisions in the future.

Fortunately, the F.A.S.T. Graphs research tool has allowed me to mark and save every buy and every sell decision on any stock I have ever owned. I often review those past decisions, even the ones that I no longer own, in order to see what I might learn. In that same vein, and for clarity regarding this article, I have added buy dots (green dots) on each of the companies that I wrote about in my March 19, 2010 articles. In part one, I covered 4 undervalued blue chips for dividends and growth Abbott Laboratories (NYSE:ABT), Clorox (NYSE:CLX), SYSCO (NYSE:SYY) and Hudson City Bancorp (NASDAQ:HCBK), and in part 2, I covered the remaining 4 - McCormick & Co. (NYSE:MKC), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG) and Automatic Data Processing (NASDAQ:ADP). With what follows, I offer the investing lessons that I believe this exercise has taught me.

Lessons on the Importance of Valuation

Early in my investing career, I was fortunate to have been taught the principle of only investing in stocks when sound valuation, or better yet, undervaluation was available. The most valuable investing principles are supported by common sense, and this one is no different. However, in the real world, with matters of investing, it is often difficult to hold onto or apply what makes sense. The emotions of fear or greed all too often get in the way. The incessant reality and persistence of daily price volatility is the main culprit. This continuously challenges our good judgment, and stimulates strong emotional responses. This can cause us to abandon reason and react irrationally when academic theory is tested and/or challenged under fire in real life situations.

Valid lessons learned in a classroom or academic setting can be easily accepted intellectually. But, there are no greater teachers than those found in the school of hard knocks. When we are investing our real money in a live stock market environment, what we really believe or perhaps fear can become separated from what we think we know and have learned. This is why experience is such a profound teacher, and why I believe it is important to continuously review our past investing behaviors and actions.

Although there are many iterations and adaptations of this old saying, here is a favorite that I found by Cynthia A. Patterson:

"Those who don't know their history are doomed to repeat it. You have to expose who you are so that you can determine what you need to become."

As I studied and reviewed what I wrote in March, 2010, the importance of the principle of sound valuation was not only reinforced, this exercise also provided me a deeper understanding of its benefits and value to me as an investor. Hopefully, through sharing some of those lessons learned, it may be of value to others.

As I review each of the 8 companies I wrote about in March of 2010, I will offer elaborations on the nuances of the significance of investing at sound value that I feel I gleaned. But first, here is a general summary of some of the most important lessons.

Investing at sound value is primarily about paying a fair and reasonable price that is supported by a business's fundamentals. Although this applies to both growth stocks and dividend paying stocks, it is most relevant to dividend payers. In this context, the fundamentals of the business are more important than short-term price volatility. In other words, as long as the business's fundamentals do not dramatically deteriorate, investing when fundamentals are sound provides a strong foundation of support for your investment.

The most interesting aspect of this principle is that even if a company's growth rate slows down, or even if growth does not meet your original forecasts or expectations, it is very unlikely that you would lose a substantial amount of money. You might not make as much as you had originally expected or hoped for, but the risk of catastrophic loss is greatly reduced. Of course, the payment of dividends over time also mitigates the risk of catastrophic loss. This aspect is related to protecting your investable dollars from the potential of a severe downside.

However, another interesting aspect of this principle relates to the opportunity for upside, or the possibility or potential of achieving attractive returns on your money. When you are investing in the highest-quality blue-chip dividend paying stocks that typically command a premium valuation (as was the case with the examples in my original series of articles on March 19, 2010), you are presented with the opportunity for what I like to call natural financial leverage. Here, I am referring to the opportunity for P/E ratio expansion as the company's valuation moves back into alignment with its historical premium norms. On the other hand, the odds are highly in your favor that you will earn a positive rate of return, even if the P/E expansion does not occur.

From the upside perspective, this means that you still have the possibility to earn very attractive returns, even when the companies do not provide the growth that you originally expected. Again, when I move to the 8 specific examples that were presented in my original series of articles, I will provide more detailed explanations of this opportunity.

Lessons learned from 8 Stocks Originally Featured on March 19, 2010

At this point, it's important to emphasize that this article is not backward-looking. Instead, this article is presenting an accountability of sorts on 8 companies that I featured in March of 2010. However, as I previously indicated, it's not the accountability that's of paramount importance. Instead, what are most important are the lessons that can be gleaned and learned from this exercise.

In order to illustrate the potential lessons, I offer the following 15 calendar year F.A.S.T. Graphs on each of the 8 companies originally highlighted. Additionally, I have added a green dot on each graph indicating the date and price when this series of articles was originally authored.

First of all, this allows me to illustrate the historical normal quality premium P/E ratios (the dark blue line) that have been applied to each of these high-quality examples. Next, this allows me to illustrate how the P/E ratios of these companies were driven to normal P/E ratio valuations (the dark orange line) that would typically be applied to other theoretical lesser-quality companies with similar earnings growth rates and dividend records as a result of the Great Recession.

The 4 Companies from Part 1

The Clorox Company - Lessons Learned

The 6-year historical earnings growth rate for Clorox since 2010 has only averaged a little over 5%, which is approximately half its long-term growth rate seen on the 15 calendar year graph. Although this is below what I expected and below consensus estimates in 2010, I consider Clorox's performance from that time acceptable considering the quality of this company.

Capital appreciation of 11.3% is very good even though it underperformed the S&P 500. On the other hand, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 13.6% I will gladly accept on any company I ever invest in.

SYSCO Corporation - Lessons Learned

The 6 year historical earnings growth rate for SYSCO since 2010 has been negative which is significantly below its long-term growth rate seen on the 15 calendar year graph. Although this is below what I expected and below consensus estimates in 2010, I consider SYSCO's performance from that time acceptable considering the quality of this company and its quasi-cyclical nature.

Capital appreciation of 7.9% is good even though it underperformed the S&P 500. On the other hand, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 10.4% I will gladly accept on any company I ever invest in.

Abbott Laboratories/AbbVie (NYSE:ABBV) - Lessons Learned

Most readers are likely aware that Abbott Labs split into two companies since my original articles were published. Consequently, it is slightly confusing to attempt to illustrate the precise performance of the parts since the article was originally published. However, the lesson learned here just might be that the parts in this case might be worth more than the whole.

On the current, Abbott Laboratories' graph I add a red dot that would normally indicate a sell. However, in this case that is not what actually happened. This was the approximate time of the company splitting in two, and therefore, the red dot simply indicates when that happened. It also appears that there was a big price drop on the ABT graph, but that is not accurate. Therefore, I added a second green dot indicating the reset value of Abbott Labs post-split up.

With these examples, I also include the current graph of ABBV. The combined performance of the two illustrates that this high-quality company, now companies, represented an excellent investment opportunity at the time ABT was highlighted.

Abbott Laboratories

AbbVie Inc.

Hudson City Bancorp, Inc. - Lessons Learned

Out of the 8 companies originally featured, Hudson City Bancorp was the only loser. However, it was also the only company that went through a significant fundamental deterioration. The earnings growth rates of some of the others slowed or weakened, but all stayed strong enough to continue to raise their dividends.

With this example, I added an additional red dot indicating when I sold the company. I did extensive research on this company before I bought it, and before I sold it. This work made it clear that the company was under enormous fundamental stress, but there were also extenuating circumstances that I would for the most part rather not rehash now. However, the company announced a merger/takeover with M&T Bank Corporation (NYSE:MTB) that I felt had potential, which kept me in the stock perhaps longer than I should have. Numerous delays in obtaining regulatory approval caused me to eventually lose my patience and I sold.

However, there is an important investment lesson that I learned from this experience that might surprise many readers. Over the years, I have learned that more often than not it can be prudent and profitable to stay with a high-quality company that is going through temporary stress. Consequently, I am instinctively more inclined to add to a position than I am to sell. The primary underlying principle behind this attitude is that a loss is not a loss until it is taken. I believe that people will too often panic and take a loss that they shouldn't. But of course, occasionally that attitude will bite you, as it did me with Hudson City Bancorp.

On the other hand, of the 8 high-quality companies that I wrote about, making good money on 7 out of 8 is a pretty good batting average. The lesson of diversification applies here.

Hudson City Bancorp generated a loss since I originally highlighted it in my article. On the other hand, this is an extreme example that was related to the financial crisis that many believe caused the Great Recession. Nevertheless, there is some solace in the fact that it was not a total loss. And interestingly, this company still generated more dividend income than the S&P 500 in spite of several dividend cuts.

The 4 Companies from Part 2

Automatic Data Processing - Lessons Learned

The 6-year historical earnings growth rate for Automatic Data Processing since 2010 has averaged a little over 6%, which is in line with its long-term growth rate seen on the 15 calendar year graph. Although this is consistent with what I expected and consistent with consensus estimates in 2010, I consider ADP's performance from that time superb considering the quality of this company.

Capital appreciation of 15% is strong, and outperformed the S&P 500. Additionally, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 16.9% was above-average and strong.

McCormick & Company, Inc. - Lessons Learned

The 6-year historical earnings growth rate for McCormick since 2010 has averaged over 8%, which is consistent with its long-term growth rate seen on the 15 calendar year graph. Although this is in line with what I expected, and consistent with consensus estimates in 2010, I consider McCormick's performance from that time superb considering the quality of this company.

Capital appreciation of 15.6% is strong, and outperformed the S&P 500. Additionally, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 17.4% was above-average and very strong.

PepsiCo - Lessons Learned

The 6-year historical earnings growth rate for Pepsi since 2010 has only averaged a little over 4%, which is approximately half its long-term growth rate seen on the 15 calendar year graph. Although this is below what I expected and below consensus estimates in 2010, I consider Pepsi's performance from that time acceptable considering the quality of this company.

Capital appreciation of 9.5% is good even though it underperformed the S&P 500. On the other hand, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 11.7% I will gladly accept on any company I ever invest in.

Procter & Gamble - Lessons Learned

The 6-year historical earnings growth rate for Procter & Gamble since 2010 has only averaged a little over 3%, which is less than half its long-term growth rate seen on the 15 calendar year graph. Although this is below what I expected and below consensus estimates in 2010, I consider Procter & Gamble's performance from that time acceptable considering the quality of this company.

Capital appreciation of 8.8% is good even though it underperformed the S&P 500. On the other hand, total cumulative dividend income was significantly greater than the S&P 500. The compounded total annual return of 11% I will gladly accept on any company I ever invest in.

Summary and Conclusions

The primary lesson that I feel this review exercise teaches is the power and protection of investing in high-quality dividend paying stocks when sound value is presented. As it relates to this article, the blue-chip dividend paying stalwarts covered rarely sell at their true intrinsic values. There are many companies of this quality that typically command a quality premium valuation. Stated more plainly, if you want to own best-of-breed companies, you must be willing to pay a premium for quality.

The Great Recession, and for a couple of years thereafter, provided the opportunity to invest in blue-chip stalwarts at their intrinsic value. On a pure fundamental basis, this did not make them excessively cheap. However, it did provide a rare opportunity to buy them at sound value. This provided several interesting benefits.

First of all, this gave dividend growth investors the opportunity to invest at a time when the current yields of these companies were above their historical norms. This would have the impact of generating more cumulative total dividend income than would normally be available. Additionally, investors were given the opportunity to get a higher yield at a lower level of real risk.

A careful analysis of the 15-year calendar graphs presented in the article illustrates that the true earnings justified valuation (the orange line) represented significant downside protection. Most of these highlighted companies never saw their stock price fall materially below the true earnings justified valuation level. In the few cases where that did happen, recovery was quick to happen. Moreover, each of these companies that maintain their fundamental strength soon saw their stock price move back to alignment with, and even above, their normal premium valuation levels.

Investing in high-quality blue-chip dividend paying stalwarts when fair valuation is manifest offers the Holy Grail for the dividend growth investor. The potential for earning higher-than-normal returns while simultaneously investing at lower-than-normal levels of risk. Investing in quality at value protects your principal, offers above-average income at reduced levels of risk. For the dividend growth investor, especially those funding their retirement - it doesn't get any better than that. The only negative is that it rarely happens, but when it does, investors should rejoice in the opportunity.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: The author is long ABT, CLX, SYY, PEP, PG, ABBV, ADP at the time of writing.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.